that are not ex goods on r services.They are the ehoushold disposable opposite of taxes:taxes reduce income, whereas transfer payment increase it.Examples of transfer payments include Social Security payments to the elderly,unemployment insurance,and veterans'benefits. 6.What makes the demand for the economy's output of goods and services equal the supply 6.Consumption,investment,and government purchases determine demand for the economy's output,whereas the factors of production and the production function determine the supply of output.The real interest rate adjusts to ensure that the demand for the conomy's goods equals the supply.At the ium interest rate,the demd forgoodsand suppy 7.Explain what happens to consumption,investment,and the interest rate when the government increases taxes. 7.When the go ernment increases taxes,disposable income falls s,and therefor consumption falls as wellThe decrease in consumption equals the amount that taxes increase multiplied by the marginal propensity to consume(MPC).The higher the MPC is,the greater is the negative effect of the tax increase on consumption.Because output is fixed by the factors of production and the productiontechnolog,a ernment purch ases ha ave not c the decreas in consumption must be offset by an increase in investment.For investment to rise,the real interest rate must fall.Therefore,a taxincrease leads to a decrease in consumption,an increase in investment,and a fall in the real interest rate. Problems and Applications 1.Use the neoclassical theory of distribution to predict the impact on the real wage and the real rental price of capital of each of the following events: .A wave of immigration ses the labor fore qu ke dest ome of the capital c.A technological advance improves the production function 1.a.According to the neoclassical theory of distribution,the real wage equals the marginal product of labor.Because of diminishing returns to labor an increase in thelabor fo causes th e marginal product of lab e,the wage falls b.The real rental price equals the marginal product of capitalIf an earthquake destroys some of the capital stock(yet miraculously does not kill anyone and lowerthe labor force),the marginal product of capital rises and,hence,the real rental price rises
that are not in exchange for goods or services. They are the opposite of taxes:taxes reduce household disposable income, whereas transfer payments increase it.Examples of transfer payments include Social Security payments to the elderly,unemployment insurance,and veterans’benefits. 6.What makes the demand for the economy’s output of goods and services equal the supply? 6.Consumption,investment,and government purchases determine demand for the economy’s output, whereas the factors of production and the production function determine the supply of output.The real interest rate adjusts to ensure that the demand for the economy’s goods equals the supply.At the equilibrium interest rate,the demand for goods and services equals the supply. 7.Explain what happens to consumption, investment, and the interest rate when the government increases taxes. 7.When the government increases taxes,disposable income falls,and therefore consumption falls as well.The decrease in consumption equals the amount that taxes increase multiplied by the marginal propensity to consume(MPC).The higher the MPC is, the greater is the negative effect of the tax increase on consumption.Because output is fixed by the factors of production and the production technology,and government purchases have not changed,the decrease in consumption must be offset by an increase in investment.For investment to rise, the real interest rate must fall. Therefore, a taxincrease leads to a decrease in consumption, an increase in investment,and a fall in the real interest rate. Problems and Applications 1. Use the neoclassical theory of distribution to predict the impact on the real wage and the real rental price of capital of each of the following events: a.A wave of immigration increases the labor force. b.An earthquake destroys some of the capital stock. c.A technological advance improves the production function. 1. a. According to the neoclassical theory of distribution, the real wage equals the marginal product of labor. Because of diminishing returns to labor, an increase in thelabor force causes the marginal product of labor to fall.Hence, the real wage falls. b.The real rental price equals the marginal product of capital.If an earthquake destroys some of the capital stock(yet miraculously does not kill anyone and lowerthe labor force), the marginal product of capital rises and, hence, the real rental price rises
c.If a technological advance improves the production function,this is likely to ase the margina produ cts of both capital and labor.Hence,the real wage and the real rental price both increase. 2.If a 10-percent increase in both capital and labor causes output to increase by less than 10 percent,the production function is said to exhibit decreasing returns to scale. ses output to increase by more than 10p productio function is aid exhibit increasing returns to scale.Why might a productio function exhibit decreasing or increasing returns to scale? 2.A production function has decreasing returns to scale if an equal percentage inerease in all factors of production leads toa smaller pere tage increase in output.For e le if we double the amoun capital and lab or,and out than dou then the production function has decreasing returns to capita and labor.This may happen if there is a fixed factor such as land in the production function,and this fixed factor becomes scarce as the economy grows larger.A production function has increasing returns to scale if an equal percentage increase in all factors of production leads to a larger percentage ncrease in outpu For example,if doubling inputs of capital and labor more than doubles output, then the production function has increasing returns to scale.This may happen if speciaiation of labor becomes greater as population grows.For orker builds a car,then it takes him a long e time beca se he has to lea rn many change tasks and tools;all of this is fairly slow.But if many workers build a car,then each one can specialize in a particular task and become very fast at it. 3.According to the neoclassical theory of distribution,the real wage any worker equals that worker's ma t's use oht to examine the incomes of two groups of workers:farmers and barbers. a.Over the past century,the productivity of farmers has risen substantially because of technological progress.According to the neoclassical theory,what should have happened to their real wage? b.In what units is the real wage discussed in part(a)measured? c.Over the same period,the productivity of barbers has remained constant.What should have happened to their real wage? d.In what units is the real wage in part(c)measured? e.Suppose workers can move freely between being farmers and being barbers. What does this mobility imply for the wages of far rmers and barbers? f.What do our previous answers imply for the price of haireuts relative to the price of food? g.Who benefits from technological progress in farming-farmers or barbers? 3.a.According to the neoclassical theory,technical progress that increases the
c. If a technological advance improves the production function,this is likely to increase the marginal products of both capital and labor. Hence, the real wage and the real rental price both increase. 2. If a 10-percent increase in both capital and labor causes output to increase by less than 10 percent, the production function is said to exhibit decreasing returns to scale. If it causes output to increase by more than 10 percent,the production function is said to exhibit increasing returns to scale. Why might a production function exhibit decreasing or increasing returns to scale? 2.A production function has decreasing returns to scale if an equal percentage increase in all factors of production leads to a smaller percentage increase in output. For example, if we double the amounts of capital and labor,and output less than doubles, then the production function has decreasing returns to capital and labor.This may happen if there is a fixed factor such as land in the production function,and this fixed factor becomes scarce as the economy grows larger. A production function has increasing returns to scale if an equal percentage increase in all factors of production leads to a larger percentage increase in output. For example,if doubling inputs of capital and labor more than doubles output, then the production function has increasing returns to scale.This may happen if specialization of labor becomes greater as population grows. For example,if one worker builds a car, then it takes him a long time because he has to learn many different skills, and he must constantly change tasks and tools; all of this is fairly slow. But if many workers build a car,then each one can specialize in a particular task and become very fast at it. 3.According to the neoclassical theory of distribution,the real wage earned by any worker equals that worker’s marginal productivity. Let’s use this insight to examine the incomes of two groups of workers:farmers and barbers. a.Over the past century,the productivity of farmers has risen substantially because of technological progress.According to the neoclassical theory, what should have happened to their real wage? b. In what units is the real wage discussed in part (a) measured? c.Over the same period,the productivity of barbers has remained constant.What should have happened to their real wage? d. In what units is the real wage in part(c)measured? e.Suppose workers can move freely between being farmers and being barbers. What does this mobility imply for the wages of farmers and barbers? f.What do your previous answers imply for the price of haircuts relative to the price of food? g.Who benefits from technological progress in farming—farmers or barbers? 3. a.According to the neoclassical theory,technical progress that increases the
wage is in dollars,then the real wage is W/PF.where PF is the dollar price of farm goods. c.If the marginal productivity of barbers is unchanged,then their real wage is unchanged. d.The al wage in(c)is measured in terms of haircuts.That is,if the no minal wag is in dollars,then the real wage is W/PH,where PH is the dollar price of a haireut e.If workers can move freely between being farmers and being barbers,then they must be paid the same wage W in each sector. f.If the nominal wage W is the same in both sectors,but the real wage in terms of farm goods is greater than the real wage in terms of hairc cuts,then the price of haircuts must have risen relative t o the price of farm goods g.Both groups benefit from technological progress in farming C HA PT E R 4 Money and Inflation Ouestions for Keview 1.Describe the functions of money. power from the present to the future.As a unit of account,money provides the terms in which prices are quoted and debts are recorded.As a medium of exchange,money is what we use to buy goods and services. 2.What is fiat money?What is commodity money? 2.Fiat money is established as money by the government but has no intrinsic value.For example,a U.S.dollar bill is fiat money.Commodity money is money that is based on a commodity with some intrinsic value.Gold,when used as oney.is an nodity money 3.Who controls the money supply and how? 3.In many countries,a central bank controls the money supply.In the United States,the central bank is the Federal Reserve-often called the Fed.The control of the ney si upply is called etary policy.The that the fed controls the money supply is through open-market operations,which involve the purchase or sale of government bonds.To increase the money supply,the Fed uses dollars to buy government bonds from the public,putting more dollars into the hands of the public.To decrease the money su pply,the Fed sells some of its government bonds,taking dollars out of the hands of the public
marginal product of farmers causes their real wage to rise. b.The real wage in(a)is measured in terms of farm goods.That is,if the nominal wage is in dollars,then the real wage is W/PF, where PF is the dollar price of farm goods. c.If the marginal productivity of barbers is unchanged,then their real wage is unchanged. d.The real wage in(c)is measured in terms of haircuts.That is,if the nominal wage is in dollars,then the real wage is W/PH,where PH is the dollar price of a haircut. e.If workers can move freely between being farmers and being barbers,then they must be paid the same wage W in each sector. f.If the nominal wage W is the same in both sectors,but the real wage in terms of farm goods is greater than the real wage in terms of haircuts,then the price of haircuts must have risen relative to the price of farm goods. g.Both groups benefit from technological progress in farming. C H A P T E R 4 Money and Inflation Questions for Review 1.Describe the functions of money. 1. Money has three functions:it is a store of value,a unit of account,and a medium of exchange. As a store of value,money provides a way to transfer purchasing power from the present to the future.As a unit of account,money provides the terms in which prices are quoted and debts are recorded.As a medium of exchange,money is what we use to buy goods and services. 2.What is fiat money?What is commodity money? 2. Fiat money is established as money by the government but has no intrinsic value. For example,a U.S.dollar bill is fiat money.Commodity money is money that is based on a commodity with some intrinsic value.Gold,when used as money,is an example of commodity money. 3.Who controls the money supply and how? 3. In many countries,a central bank controls the money supply. In the United States, the central bank is the Federal Reserve—often called the Fed.The control of the money supply is called monetary policy. The primary way that the Fed controls the money supply is through open-market operations,which involve the purchase or sale of government bonds. To increase the money supply,the Fed uses dollars to buy government bonds from the public,putting more dollars into the hands of the public.To decrease the money supply,the Fed sells some of its government bonds,taking dollars out of the hands of the public
6.Who pays the inflation tax? 6.The holders of money pay the inflation tax.As prices rise,the real value of the money that people hold falls-that is,a given amount of money buys fewer goods and services since prices are higher. 8.List all the costs of inflation you can think of,and rank them according to how important you think they are. 8.The costs of expected inflation include the following: mean that people want to money balances,they must make more frequent trips to the bank to withdraw money.This is inconvenient(and it causes shoes to wear out more quickly). b.Menu costs.Higher inflation induces firms to change their posted prices more often.This may be costly if they must reprint their menus and catalogs. c.Grea variability in relative s.If firms chan theirprices the tion causes greater prices.Since fre-marker economies rely on relative prices to allocate resources efficiently,inflation leads to microeconomic inefficiencies. d.Altered tax liabilities.Many provisions of the tax code do not take into account the effect of inflation.Hence,inflation can alter individuals'and firms'tax liabilities,ofe in ways that a s did notir e.The inconvenience of a changing price level.It is inconvenient to live in a world with a changing price level.Money is the yardstick with which we measure eco- nomic transactions.Money is a less useful measure when its value is always han rary redistributions of wealth.Unexpected inflatior redistributes wealth among individuals.For example,if inflation is higher than expected,debtors gain and creditors lose.Also,people with fixed pensions are hurt because their dollars buy fewer goods. 9.Explain the roles of monetary and fiscal policy in causing and ending hyperinflations 9.A hyperinflation always reflects monetary policy.That is,the price level cannot grow rapidly unless the supply of money also grows rapidly;and hyperinflations do not end unless the money owth.This expla ion,h ver, central que tion:Why does the govern star then stop printing lots of money?The answer almost always lies in fiscal policy:When the government has a large budget deficit(possibly due to a recent war or some other major event)that it can not fund by borrowing,it resorts to printing money to pay its bills.And only when this fiscal problem is
6.Who pays the inflation tax? 6.The holders of money pay the inflation tax.As prices rise,the real value of the money that people hold falls—that is,a given amount of money buys fewer goods and services since prices are higher. 8.List all the costs of inflation you can think of, and rank them according to how important you think they are. 8.The costs of expected inflation include the following: a. Shoeleather costs.Higher inflation means higher nominal interest rates,which mean that people want to hold lower real money balances.If people hold lower money balances,they must make more frequent trips to the bank to withdraw money.This is inconvenient(and it causes shoes to wear out more quickly). b. Menu costs.Higher inflation induces firms to change their posted prices more often.This may be costly if they must reprint their menus and catalogs. c. Greater variability in relative prices. If firms change their prices infrequently, then inflation causes greater variability in relative prices.Since free-market economies rely on relative prices to allocate resources efficiently, inflation leads to microeconomic inefficiencies. d. Altered tax liabilities.Many provisions of the tax code do not take into account the effect of inflation.Hence,inflation can alter individuals’and firms’tax liabilities, often in ways that lawmakers did not intend. e.The inconvenience of a changing price level. It is inconvenient to live in a world with a changing price level. Money is the yardstick with which we measure economic transactions. Money is a less useful measure when its value is always changing. There is an additional cost to unexpected inflation: f.Arbitrary redistributions of wealth.Unexpected inflation arbitrarily redistributes wealth among individuals.For example,if inflation is higher than expected, debtors gain and creditors lose.Also,people with fixed pensions are hurt because their dollars buy fewer goods. 9.Explain the roles of monetary and fiscal policy in causing and ending hyperinflations. 9. A hyperinflation always reflects monetary policy.That is,the price level cannot grow rapidly unless the supply of money also grows rapidly;and hyperinflations do not end unless the government drastically reduces money growth. This explanation,however, begs a central question:Why does the government start and then stop printing lots of money? The answer almost always lies in fiscal policy:When the government has a large budget deficit(possibly due to a recent war or some other major event)that it can not fund by borrowing,it resorts to printing money to pay its bills.And only when this fiscal problem is
alleviatedby reducing government spending and collecting more taxescan the government hope to slow its rate of money growth. l0.Define the terms"“real variable”and“nominal variable,.”and give an example ofeach. 10.A real variable is one that is measured in units that are constant over -for example,they might be measured in "constant dollars."That is,the units are adjusted forinflation.A nominal variable is one that is measured in current dollars;the value of the variable is not adjusted for inflation. For example,a real variable could be a Hershey's candy bar:the nominal variable is the current-price value of the Hershey's candy bar -5 cents in 1960,say,and 75 cents in 1999.The interest rate you are quoted I by your bank percent,say-is a nominal rate,since it is not adjusted for inflation.If inflation is, say,3 percent,then the real interest rate,which measures your purchasing power, is 5 percent. Problems and Applications 1.What are the three functions of money?Which of the functions do the following items satisfy?Which do they not satisfy? c.A subway token 1.Money functions as a store of value,a medium of exchange,and a unit of a.A credit card can serve as a medium of exchange because it is accep exchange for goods and services.A credit card is,arguably,a(negative)store of value because you can accumulate debt with it.A credit card is not a unit of account-a car for example,does not cost 5 VISA cards. b.A Rembrandt painting is a store of value only. c.A subway tok ithi a the atisfies all three functions of money. Yet outside the subway system,it is not widely used as a unit of account ora medium of exchange.so it is not a form of monev. 3.A newspaper article written by the Associated Press in 1994r US riencing a low illion recipients of Social Security and other benefits see their checks go up by just 2.8 percent next year." a.Why does inflation affect the increase in Social Security and other benefits? b.Is this effect a cost of inflation as the article suggests?Why or why not?
alleviated—by reducing government spending and collecting more taxes—can the government hope to slow its rate of money growth. 10. Define the terms“real variable” and “nominal variable,” and give an example of each. 10.A real variable is one that is measured in units that are constant over time—for example, they might be measured in “constant dollars.” That is, the units are adjusted forinflation. A nominal variable is one that is measured in current dollars; the value of the variable is not adjusted for inflation. For example, a real variable could be a Hershey’s candy bar; the nominal variable is the current-price value of the Hershey’s candy bar—5 cents in 1960,say,and 75 cents in 1999. The interest rate you are quoted by your bank—8 percent, say—is a nominal rate,since it is not adjusted for inflation. If inflation is, say, 3 percent, then the real interest rate,which measures your purchasing power, is 5 percent. Problems and Applications 1.What are the three functions of money? Which of the functions do the following items satisfy? Which do they not satisfy? a.A credit card b.A painting by Rembrandt c.A subway token 1.Money functions as a store of value,a medium of exchange,and a unit of account. a.A credit card can serve as a medium of exchange because it is accepted in exchange for goods and services.A credit card is,arguably,a(negative)store of value because you can accumulate debt with it.A credit card is not a unit of account—a car,for example,does not cost 5 VISA cards. b.A Rembrandt painting is a store of value only. c.A subway token,within the subway system,satisfies all three functions of money. Yet outside the subway system,it is not widely used as a unit of account or a medium of exchange,so it is not a form of money. 3.A newspaper article written by the Associated Press in 1994 reported that the U.S.economy was experiencing a low rate of inflation. It said that“low inflation has a downside: 45 million recipients of Social Security and other benefits will see their checks go up by just 2.8 percent next year.” a. Why does inflation affect the increase in Social Security and other benefits? b. Is this effect a cost of inflation as the article suggests?Why or why not?